Humanities, Then and Now

Volume XXIX Number 1

Fall 2006

The Backdating Game

A widespread Securities and Exchange Commission investigation of dozens of U.S. companies is thanks, in part, to research conducted by Randall Heron, associate professor of finance at Indiana University’s Kelley School of Business in Indianapolis, and Erik Lie of the University of Iowa.

In 2005, Lie published a study looking at 5,977 stock option grants issued between 1992 and 2002. A stock option gives a buyer the right to buy stock at a set price, say $50, in the future. The set price is normally the market value on the date the option is granted. Lie detected a pattern of low stock returns before corporate executive stock option grants and abnormally high returns immediately after. He hypothesized that, unless executives had some unusual ability to forecast the future, they were most likely backdating their stock option grants. Backdating means insiders choose a date days or even months in the past when the stock price was low, say $30, as the date for their stock option grants. By altering the dates, executives locked in the lower purchase price, then profited from stock price increases that had already occurred.

In a second study last year, Heron and Lie refined and validated Lie’s hypothesis, fueling a sweeping national investigation into what Fortune magazine called "an options-backdating brouhaha." The study has captured the attention of The New York Times, Wall Street Journal, Business Week, U.S. News & World Report, and The Economist, among others.

In their study, forthcoming in The Journal of Financial Economics, Heron and Lie examined stock price behavior around executive stock option grants before and after the Sarbanes-Oxley Act (SOX), which the SEC implemented in 2002. One of the act’s provisions tightened reporting requirements for option grants. Before the regulatory change, option grants to executives did not have to be reported until 45 days after the close of a company’s fiscal year. Under SOX, option grants must be reported to the SEC within two days.

The dramatic regulatory change made for a "natural laboratory for testing the backdating hypothesis," write Heron and Lie. Before the 2002 changes, they found an abnormal pattern of significant stock price declines leading up to executive option grants, followed by significant stock price increases after the grants. In the post-SOX period, about 80 percent of the abnormal stock returns disappeared. "This suggests that most, if not all, of the pattern before August 29, 2002, is attributable to the effects of backdating," the co-authors say.

But even under the new regulations, backdating still takes place. Roughly one-fifth of the option grants made since the regulatory change were not reported to the SEC within the two-day requirement, according to Heron and Lie. On average, these late filers saw the value of their stock decline about 3 percent in the 30 days prior to the grant date and rise more than 7 percent in the 30 days following the declared date. This favorable stock price pattern suggests that even after SOX, companies have continued the practice of backdating options for executives to boost the value of their stock options.

In July, Heron and Lie posted a working paper on the Web that looks more closely at what fraction of executive stock option grants have been backdated. They estimate that nearly 30 percent of the firms they examined manipulated grants to their top executives at some point between 1996 and 2005.

There is ongoing debate about whether backdating stock options is illegal or "merely slimy," as Fortune magazine put it. In any case, companies are getting into trouble for improper accounting of backdated option grants in financial reports and taxes.

"The SEC has taken the position that this erroneous reporting represents financial fraud and is investigating numerous companies who will likely, in addition to possibly paying penalties, be forced to restate their earnings," Heron says. "Backdating stock options so that executives are already in-the-money and disguising the practice can be compared to letting executives bet on a game where they already know the final score."